The spectre of worthless oil assets

In a speech a few months ago, the head of the Bank of England, Mark Carney, warned London’s insurers of the “profound implications” of climate change, identifying one of the biggest risks for the world’s financial markets as the possibility that much of the world’s oil assets could end up worthless. The value of oil […]

In a speech a few months ago, the head of the Bank of England, Mark Carney, warned London’s insurers of the “profound implications” of climate change, identifying one of the biggest risks for the world’s financial markets as the possibility that much of the world’s oil assets could end up worthless.

The value of oil reserves is an old debate, as Bob Dudley, the chief executive of BP, said when asked about Mr Carney’s comments.

Oil companies’ reserves – and all other mining company assets – have always been a matter for investors to assess, Mr Dudley said, adding that he had had a word with Mr Carney to complain about the views expressed.

But the central bank governor was not talking just about the industry’s usual valuation challenges, which traditionally focus on assessing whether oil can be recovered at an economic price. Mr Carney was talking about an existential threat based on demand for oil disappearing.

The international agreement at the Paris summit last month to limit carbon emissions so that temperatures will not rise by more than 2°C translates to between one-fifth and one-third of the world’s proven oil, gas and coal reserves, he noted.

“If that estimate is even approximately correct it would render the vast majority of reserves stranded – oil, gas and coal that will be literally unburnable without expensive carbon-capture technology, which itself alters fossil-fuel economics,” Mr Carney warned.

In other words, institutional investors who manage much of the world’s savings face a different order of risk now for oil and gas investments because of this huge policy shift.

Although Mr Dudley dismissed this worry, he also noted that BP had recently passed the 50 per cent mark in terms of the amount of the company’s output that came from natural gas, with oil now being below that threshold.

“By the end of the decade that will be 60 per cent, and I can see the day very clearly out there in the next decade where it will be two-thirds natural gas,” said Mr Dudley.

That is a clear expression of where BP sees value – and risk – in the future, and one that has been made at least as emphatically by its peers, including Royal Dutch Shell and Total, which are on a similar path to emphasise gas over oil.

The risk identified by Mr Carney is starting to sink in with investors too, as underlined last May when Axa, France’s biggest insurance company, said it would divest more than US$550 million of coal assets, a move followed by other big institutions.

Last year’s drop in oil prices led to a collapse in industry deal-making worldwide to their lowest level in more than a decade, according to Wood Mackenzie, which tracks the industry closely. It would have been even worse if not for Shell’s $82 billion takeover of BG, which was intended to boost Shell’s gas assets.

The market tends to be dominated by short-term oil price considerations, “but it’s something we were thinking about when the Paris climate change conference was on, if the idea of stranded assets will be a driver for disposals of assets,” said Luke Parker, the head of Woodmac’s mergers and acquisitions research. “It is something that these companies will have in the back of their minds, and increasingly it is coming to the forefront of their minds.”

It becomes a very large question when that company is Saudi Aramco, which is studying (as disclosed by the deputy crown prince Mohammed bin Salman in an interview with The Economist) a partial stake sale.

There was much breathless coverage of the potential value such a deal could put on Aramco, although the likelihood seems remote. Nevertheless, the fact that talk of the potential valuation – the wealth of which is based on the kingdom’s estimated 268 billion barrels of oil reserves – varied by trillions of dollars is just a hint of the difficulty of valuing oil in the ground.

It is especially tricky to try to value Aramco because of the sheer scale of its reserves, which may represent production of another 100 years, said Sebastien Henin, the head of asset management at The National Investor, an Abu Dhabi investment and advisory company.

The scale of an Aramco IPO would have to be so large, even if it were just 5 to 10 per cent of the company, that foreign investors would need to be allowed to buy shares to make it work, said Mr Henin.

But that would entail a thorough audit of the company’s oil assets and their likely value, hitherto viewed as a state secret. In any case, Saudi Arabia is not likely to sell off even a small portion of its “crown jewels” to foreign investors, Mr Henin reckons.

But just contemplating the difficulty in valuing Aramco’s oil assets – with the possibility that a large portion may end up worthless – underlines the industry’s fundamental problem.